We develop a penalized two-pass regression with time-varying factor loadings.

The penalization in the first pass enforces sparsity for the time-variation drivers

while also maintaining compatibility with the no-arbitrage restrictions by regular-

izing appropriate groups of coefficients. The second pass delivers risk premia esti-

mates to predict equity excess returns. Our Monte Carlo results and our empirical

results on a large cross-sectional data set of US individual stocks show that pe-

nalization without grouping can yield to nearly all estimated time-varying models

violating the no-arbitrage restrictions. Moreover, our results demonstrate that the

proposed method reduces the prediction errors compared to a penalized approach

without appropriate grouping or a time-invariant factor model